Blockbuster: Movie Business Remains a Moving Target

Blockbuster: Movie Business Remains a Moving Target

Though it may be hard to believe, there was a time when bright blue-and-yellow Blockbuster signs did not grace every strip mall and service road in the U.S.

But like Starbucks and Wal-Mart, Blockbuster has become a fixture in towns big and small, seemingly overnight. In the 20 years since its founding in 1985, Blockbuster Inc. has opened 9,100 stores in 25 countries.

During that time, it has rented millions of movies, and pushed the owners of countless mom-and-pop video stores into early retirement. Blockbuster has also become the conduit of choice for major Hollywood studios looking to move their hits into the home.

For the most part, when any new technology threatened the $6 billion Dallas-based juggernaut's business model, it coolly assimilated it and capitalized on the change. When the popularity of the DVD quickly overtook VHS, Blockbuster simply dumped most of its aging videocassettes and happily embraced the slimmer, cheaper, more durable optical discs. Thanks in large part to Blockbuster's switch, DVDs have mushroomed, from 22 percent of the home video entertainment market in 2000, to more than 90 percent today. Some experts predict Blockbuster will discard its entire tape inventory within the next two years.

But DVDs brought about some other, less welcome, changes for Blockbuster. The inexpensive nature of DVDsthe studios priced them around $20 at wholesale, as opposed to the $80 they were charging for VHS "rental-priced" cassettesbrought about a fundamental change in the dynamics of the movie rental business. Consumers were suddenly able to buy movies at a reasonable retail price soon after they had become available for rental. And about five years ago, that's exactly what they started doing. That struck at the heart of the $6.8 billion video rental market, of which Blockbuster holds a 40 percent share.

Then, in 1998, a pesky dot-com by the name of -Netflix Inc. appeared on the scene, proposing to mail DVDs to customers, thus saving them the expense of late fees, and the hassle of a trip to the local Blockbuster.

Blockbuster's financials began a rollercoaster ride and the stock price plummeted from a high of more than $18 in 2002, to less than $10 today. Last year, the company declared a $1.2 billion loss, thanks in part to a costly spin-off from former parent company, Viacom Inc. All of this drew the interest of the infamous corporate raider Carl Icahn, who snatched up shares on the cheap, ultimately acquiring 9 percent of the company, and earning himself a seat on the board this past May.

He has been publicly butting heads with CEO John Antioco, insisting that Blockbuster should tread water and reap the profits from its dominant position in a mature, possibly dying, industry rather than investing in high-risk technologies such as online rentals.

But Antioco has remained steadfast in his belief that online rentals are the only growth segment in an otherwise shrinking industry. Kagan Research LLC says online rental revenues jumped from virtually nothing when Netflix started in 1998, to $522 million in 2004. The analyst firm expects the industry to grow to $931 million by the end of this year, and to $2.9 billion in 2009.

And so, by late 2003, Blockbuster executives were feverishly putting the final touches on some major competitive restructuring, most of which would roll out in 2004.

Antioco earmarked tens of millions of dollars for several key initiatives to revitalize the core rental business and create new revenue: Online rentals, an in-store monthly subscription service called Movie Pass, a video game subscription service called Game Pass, a movie and games trading program, and the still controversial "No More Late Fees" effort.

Some of the new programs mimicked those of Blockbuster's competitors, some were entirely new business models, and some were pure marketing shtick. But coming along for the ride on each and every one was CIO John Polizzi and Blockbuster's IT department. The metamorphosis Blockbuster underwent in 2004 touched every part of IT, and it is a process that continues today. "It was a monster year," recalls Polizzi, a 30-year veteran of the IT business. "It was the most complex set of initiatives that I've seen a company take on. There was no shortage of things to do."

The Netflix Effect

Blockbuster doesn't publicly break out the cost of individual IT efforts, although a $100 million jump in capital expenditures from 2003 to 2004even factoring in the cost of 160 new storesindicates the overall restructuring effort has been huge. Among the biggest expenses has been Blockbuster's head-to-head response to Netflix.

After initially pooh-poohing the lack of immediacy and spontaneity in renting movies from an online subscription service, Blockbuster rapidly learned how to sing the online subscription hallelujah chorus. Netflix's market share jumped from 2 percent in 2003 to 7 percent in 2004. And the Internet upstart already has more than three million subscribers and expects to hit four million by the end of this year. Blockbuster had just under one million online rental subscribers at last count and hopes to be up to two million by early 2006.

Rather than trying to build an online mirror of its physical stores, Blockbuster instead established a separate online division in new offices situated about two blocks from its Dallas headquarters. That was a huge gamble, notes Frank Paci, executive vice president of finance and accounting, strategic planning and development. "The online business was a financial leap of faith, as opposed to the in-store initiatives, where we could try it out in a couple places and then change the system as needed," he says. "With online, we had to build the system before we had any customers for it. And you can't just try it out. The moment you're online, somebody in Alaska and somebody in Florida can use it."

That meant developing an entirely new business model inside Blockbuster's existing one, Polizzi notes, not just writing a new set of applications. At the outset, Blockbuster had roughly 100 IT people devoted to the effort, both from within the company and from outside IT consultancy Accenture.

"Now we're building our own internal capability to support the business," says Polizzi. Blockbuster also has contracted with India-based Infosys for both onshore and offshore IT help.

Why bring in outside IT resources? "Typically, when you start something new like this, you don't know what you don't know," Paci says. "You anticipate that there will be things you didn't anticipate and you need the flexibility to deal with that."

Such rapid expansion requires easy access to top IT people, Polizzi adds.

"The need to be able to extend your resource capability quickly with strong, skilled and competent people is critical," he says. "Infosys right now provides mostly onshore resources, but we're working with them with the idea that we'll eventually move some of it offshore."

Company Profile

Company: Blockbuster Inc.

Corporate Headquarters: Dallas

CIO: John Polizzi

Revenues: $6.1 billion(trailing 12 months)

EBITDA: $1.42 billion (ttm)

Stock Price: $8.35 (July 22, 2005)

52 week high-low: $6.50$13.95

A key part of taking down Netflix will be figuring how best to leverage the existing 4,500 stores in Blockbuster's domestic network. Rather than relying solely on its 30 distribution centers scattered around the countryNetflix has 35Blockbuster has created pilot programs in which store clerks can use the slow retailing hours between 10 a.m. and 4 p.m. to prepare and ship out online orders. And online subscribers can use two coupons each month to get free 7-day and new-release rentals at any Blockbuster store.

"They have a chance to eat Netflix's lunch," says Michael Pachter, a senior research analyst at Wedbush Morgan Securities in Los Angeles.

With each store operating as a distribution center, he notes, Blockbuster will be able to wield one or two orders of magnitude more inventory than Netflix. "WebVan was going to put grocery stores out of business and eToys was going to put toy stores out of business. But you like to touch the tomatoes and try the pants on. People want to browse through a physical store. That constituency isn't ever going away."

Store Fronts Remain a

Major Asset">

For those who like to browse the store every time they're in the market for a movie, Blockbuster created an entirely separate, in-store subscription service it calls Movie Pass, which allows renters to pay a monthly fee to keep a set number of movies from an individual store for as long as they want. While it would seem logical to let in-store subscription customers transact with Blockbuster Online, and vice versa, the complexities of revenue recognition and inventory management make that impossible. "If a member is paying, say, $25 per month to rent X number of movies, we need to allocate that monthly fee per movie in order to pay the studios," Paci explains. "That means we need to know which inventory it came from and who paid what for the rental."

Compounding the pain that the new online venture caused for IT was Blockbuster's massive, and nearly disastrous, "No More Late Fees" program, launched in January 2005. The drastic change to their business model gambled $250 to $300 million in annual late-fee revenue in hopes of attracting wayward customers back to the stores. It worked . . . sort of. The program has increased in-store rentals, though Blockbuster isn't saying by how much. But those customers who failed to read the fine print howled with outrage when they found the full retail price of a movie on their credit card invoices. As it turned out, "no more late fees" did not mean "no more due dates." Blockbuster records a rented movie as a sale if the customer keeps it more than seven days. If the movie is returned within 30 days, the price of the movie is credited back to the customer's accountless a $1.25 restocking fee. Keep the movie more than a month, and it's yours permanently.

Swamped with complaints, several state attorneys general filed false advertising claims against Blockbuster. All but one of those claims was dismissed after Blockbuster began a multimedia advertising campaign to clarify the program's details.

But the false advertising claims weren't the No More Late Fees initiative's only missteps. The IT department had its share of trouble persuading the stores' on-site servers to recognize the new rules; daily inventory management and sales transactions are handled at each store by a roughly ten-year-old Digital Equipment Corp. Alpha server.

"When customer service representatives are standing in front of you at the registers, the business rules are all driven off that DEC server," Polizzi says. "We had to deploy the rules in such a way that if the U.K. isn't using No More Late Fees, which they aren't, they can continue to run their business with late fees. And when Canada decided to join No More Late Fees in February, we had to be ready to transition and support that business as well."

Behind the scenes, IT needed to keep an eye on how the myriad changes were affecting inventory, rental volume and sales. "We were out in the stores doing a soft launch of the No More Late Fees program, without advertising, on Dec. 27, which is memorable for me because it's my wife's birthday," Polizzi says. "It was a very interesting holiday season last year."

Trade

-ins: More Complicated Than They Look">

Adding to the complications of that holiday season was Blockbuster's new in-store DVD trading program, quietly rolled out in more than 2,600 stores last year and expected to be in 1,600 more by the end of this year.

The idea is to let customers bring in used movies they no longer want and walk out with others. Sounds simple enough. Turns out, however, that many states require such a trading program to adhere to the same regulations required for pawnshopsan entity for which every state has slightly different laws. "You have to be a certain age to trade, you have to keep records of who is trading what, and how often, in case there's an attempt to traffic in stolen goods, and all of that is taking place at the same time you're developing an entirely new category of inventory," Polizzi says. "When you go through 50 states, and 25 countries and 9,100 stores globally, understanding all those variables, and making it effective for the people who have to account for the supply chain, is a key part of what we have do through IT."

Rounding out Polizzi's year from hell was Blockbuster's push into an entirely new rental market: video games. As each new gaming console has come out, players increasingly have been loathe to plunk down $50 to $75 to buy a game that they have never tried before. With at least three new game consoles coming out in the next 18 months, Blockbuster sees a potentially, well, blockbuster revenue opportunity.

By some measures, video game rentals and retail combined already represent nearly 20 percent of Blockbuster's business. But analysts already see plenty of potential pitfalls. "Some Blockbuster video game departments seem to do very well, while others don't at all. It's very mixed right now," says Dennis McAlpine, managing director of media and entertainment consultancy McAlpine Associates LLC, in Scarsdale, N.Y.

In their traditional video rental space, Blockbuster has two decades of data about what inventory needs to be located where in order to make the most money. Without the same kind of detailed data in the games space, and little experience determining which selection will be a hit and which a dud, "you can end up with a lot of bad inventory if you buy at the wrong time," McAlpine warns. IT is confident its systems can quickly collect the data needed to avoid that trap, and Blockbuster is confident that the new Game Pass subscription modelwhich, for $19.95 per month, allows renters to keep any one game indefinitelywill explode as new consoles hit the market.

Can Video

-on-Demand Economics Work?">

Now that 2004 has drawn to a close, and plans for 2005which include expansion of the trading and Game Pass subscription programshave been set in motion, Blockbuster is busy eyeing the technologies that will become a priority in 2006. As an example of how quickly a new technology can affect, and threaten, Blockbuster's business, consider the words of CFO Larry Zine, who, last February, said of video-on-demand, "We don't think the economics work well right now." Then, during the company's annual call with analysts and investors the following month, Blockbuster announced that it had launched successful trials of video-on-demand in both the U.K. and the U.S., and that it plans to start its own VOD service through Blockbuster Online next year. Meanwhile, Netflix will be rolling out its own service for downloading movies from the Internet later this year.

Blockbuster still has the brand recognition and the marketing muscle to become a big player in video-on-demand, should the markets move in that direction. "VOD is the ultimate impulse decision," says Jennifer Illes, a research assistant at Harvard Business School who has co-authored a series of case studies about Blockbuster's transition. "Coupled with TiVo (or any brand of digital video recorder) it's the ultimate threat. There's been so much speculation about VOD being just around the corner, and it's not totally here yet, but with those two together you have the ability to get any movie you want at any time.

That could be to Blockbuster's advantage, though, if the company can make its mark in the new technology even as its traditional business model fades awaysomething that even Carl Icahn expects it to do. That could explain why CEO Antioco is so determined to take advantage of each new business opportunity. If VOD is a potential Blockbuster-killer, like Netflix before it, he wants to keep the Blockbuster brand at the forefront of VOD's adoption so that the company can replace any rental revenues lost to the new technology.

Yet others scoff at the idea of VOD taking so much as a nibble from either the rental or sale markets in DVDs. "VOD is a joke," says analyst Pachter. "The studios know it doesn't make economic sense to allow VOD at the same time as rental. Pixar Animation [shares] blew up because they only shipped 20 million copies of The Incredibles. What if they had no DVD sales at all? Literally 50 percent of studio profits come from DVD sales. The studios recognize the need for that gap, the window, between DVD release for rental and sales, and either pay-per-view or VOD."

The technology isn't even ready for prime time, Pachter warns. "You can't have dedicated bandwidth for 40,000 movies on demand all the time, which means you'll never get the same selection you get at the video store." Besides, he says, a number of U.S. households don't even have computers, much less broadband access. "It's not going to be a threat for at least ten years and it's foolish to look beyond that."

Perhaps. But Illes notes that the studios have two opposing views of the new technology. "They're very dependent on Blockbuster because home video rental is a huge chunk of their revenues," she says. "But Blockbuster is the middleman. If they could somehow get rid of them, then VOD could be extremely lucrative for the studios. Whether VOD is an ultimate threat for Blockbuster is dependent on how the studios end up handling their release windows."

And, of course, on how nimbly Blockbuster rolls with the changes.

Janet Rae-Dupree, the technology editor for the Silicon Valley Business Journal, has covered technology and science in Silicon Valley for a number of publications, including BusinessWeek and the San Jose Mercury News.